malaysia is-lm analysis

DESCRIPTION OF MALAYSIAN MACROECONOMICSPERIOD OF 1996 - 2006

( IS-LM ANALYSIS )

ASSIGNMENT FOR MACROECONOMICS COURSEFACULTY OF ECONOMICS AND BUSINESS

NATIONAL UNIVERSITY OF MALAYSIA

By: IWAN BUDHIARTA

(P-46048)

INTRODUCTION

In 1968 Malaysia removed restrictions on payments and transfers for current international

transactions, accepting the obligations of the IMF’s Article VIII. Exchange and capital account

regulations were relaxed further in 1973, and Malaysia moved from a fixed to a floating

exchange rate. Subsequently the authorities gradually liberalized capital controls, particularly in

1986–87.

GDP and Interest Rate data from 1990 – 2007 can be seen on the table below:

Table 1. GDP-Interest Rate in Malaysia (1990-2007)Year GDP (Million RM) Interest Rate (%)

1990 119,082 6.49

1991 135,123 7.57

1992 150,682 8.1

1993 172,194 7.21

1994 195,461 5.14

1995 222,473 6.76

1996 253,733 7.39

1997 281,795 8.70

1998 283,243 6,46

1999 300,764 2,66

2000 356,401 2,79

2001 352,579 2,79

2002 383,213 2,73

2003 418,769 2,74

2004 474,048 2,70

2005 522,445 2,72

2006 573,736 3,40

2007 641,864 3,50Source: Asian Development Bank (ADB), 1990-2007

GDP data that can be seen from above showed us a bullish movement trendline from 1990-

2007. The main reason of this GDP bullish trend is come from the increasing internal trade and

strong external demand. And from supply side, the higher economic development that growing

sustainably mainly came from a strong industrial and manufacturing sector.

An interest rate level that patterned in the trendline has shown a very fluctuate movement.

Before a global financial crisis in 1997-1998, interest rate level always tried to reach a higher

level. This is just because the Malaysian government used a basic principle, which was a tight

money policy program. And this higher level of interest rate will influence and boost people to

save their money in the banks account, so that there was a lot of fund available for a new

investment proposal. Further, Malaysian government policy will develop an investment loans for

the real sector, mainly for small and medium enterprises. (look at Chart 1).

Chart 1. Interest Rate and GDP Combination.

Some of fiscal and monetary policy has taken by Federal Government from 1990-2007 (before

and after the global financial crisis) :

1992

The Federal Government policies:

- An increasing interest rate has reach the top at 1992 which has caused increasing level of GDP.

From the IS-curve, the Federal Government has implemented an Expansionary Fiscal Policy,

with increasing government expenditure and other increasing import activities in order to

develop a national economics.

- Total borrowing by residents in foreign currency from domestic commercial and merchant banks

to finance imports of goods and services was restricted to the equivalent of RM 1 million

(previously there were no limits).

2006

2000

1997

1998

1999

1994

1992

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Eq. >> Y = C + I + G

- Borrowing under the Export Credit Refinance Facilities (both pre- and post-shipment financing)

by non-resident controlled companies would be considered domestic borrowing.

- Offshore guarantees obtained by residents to secure domestic borrowing, except offshore

guarantees (whether denominated in ringgit or foreign currency) without recourse to Malaysian

residents and obtained from the licensed offshore banks in Labuan to secure domestic

borrowing, were deemed as foreign borrowing. In cases where an offshore guarantee is

denominated in ringgit, it was subject to the condition that, in the event the guarantee is called

on, the licensed offshore banks in Labuan must make payments in foreign currency (with some

exceptions), not in ringgit.

- The guidelines on foreign equity capital ownership were liberalized. Companies exporting at

least 80 percent of their production were no longer subject to any equity requirements, whereas

companies exporting between 50 percent and 79 percent of their production were permitted to

hold 100 percent equity, provided that they have invested $50 million or more in fixed assets or

completed projects with at least 50 percent local value added and that the company's products

do not compete with those produced by domestic firms. These guidelines were not to apply to

sectors in which limits on foreign equity participation have been established.

- Residents and the offshore companies in Labuan were prohibited from transacting with the

residents of dealing in the currency of the FYR Yugoslavia (Serbia and Montenegro) without

specific prior approval from the Controller of Foreign Exchange.

1994

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- A ceiling was placed on the net external liability position of domestic banks (excluding trade-

related and direct investment inflows).

- Residents were prohibited to sell the following Malaysian securities to nonresidents: banker’s

acceptances; negotiable instruments of deposit; Bank Negara bills; treasury bills; government

securities (including Islamic securities) with a remaining maturity of one year or less.

- Residents were prohibited to sell to nonresidents all forms of private debt securities (including

commercial papers, but excluding securities convertible into ordinary shares) with a remaining

maturity of one year or less.

- The restriction on the sale of Malaysian securities to nonresidents was extended to both the

initial issue of the relevant security and the subsequent secondary market trade.

- Prohibition of forward transactions (on bid side) and nontrade-related swaps by commercial

banks with foreign customers to curtail the speculative activities of offshore agents seeking long

positions in ringgit (lifted on August 16, 1994).

- Residents were permitted to sell to nonresidents any Malaysian securities.

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- Residents may borrow in foreign currency up to a total of the equivalent of RM 5 million from

nonresidents and from commercial and merchant banks in Malaysia.

- Nonresident-controlled companies were allowed to obtain credit facilities, including immovable

property loans, up to RM 10 million without specific approval, provided that at least 60 percent

of their total credit facilities from banking institutions were obtained from Malaysian-owned

financial institutions.

- Nonresidents with valid work permits may obtain domestic borrowing to finance up to 60 percent

of the purchase price of residential property for their own accommodation.

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1997

In the fall of 1997, the currency crisis that began in Thailand reached Malaysia. The ringgit, the

Malaysian currency, would lose nearly two-fifths of its value by August 1998. The stock market

fell even more severely, with the main Kuala Lumpur Stock Exchange composite index losing

three-quarters of its value over the same period. The net inflow of capital into Malaysia was cut

in half as net portfolio investment turned highly negative and remained negative through 1998.

The Malaysian economy slowed during the second half of 1997, then crashed in 1998,

contracting by 6.7 percent. Construction, real estate, and manufacturing were all hard hit.

Employment contracted across the economy and jobs for foreign workers disappeared. Still, all

told, the economic crisis did less damage in Malaysia than in either Thailand or Indonesia. And

unlike the Indonesian economy, which remained mired in crisis, the Malaysian economy began

to recover during 1999, growing 4.3 percent, about one-half the rate it had averaged over the

previous decade.

Jomo and Rajah Rasiah, a Malaysian economist who has written extensively about foreign

capital flows into Malaysia, establish that at the onset of the crisis Malaysia's "first order

macroeconomic conditions" were in good shape and were characterized by sustained rapid

growth, relatively mild inflation, and fiscal discipline. What plagued the Malaysian economy was

a persistent current account deficit dangerously financed by short-term capital flows.

Unlike Thailand and Indonesia, which relied on borrowing from foreign banks to cover much of

their current account deficits, Malaysia turned to the capital markets to finance its current

account deficit, for prudential regulation limited bank borrowing from abroad. When the crisis hit,

both types of short-term capital flows - foreign bank lending and stock buying - reversed

themselves with little regard for the actual strength of these economies. But, as Jomo and his

colleagues establish, Malaysia's closer regulation left its banking sector in better shape and

thereby muted the impact of the crisis in Malaysia.

Since the Asian financial crisis that began in 1997, the Government has maintained a fiscal

pump-priming policy to boost domestic demand, aimed at preventing recession and keeping

unemployment down, in the wake of volatility and uncertainty in the global economy. In 2001

and 2002, the Government continued its expansionary fiscal policies to stimulate investment

and production (Figure 4). Reflecting this, public consumption (accounting for about one fourth

of total consumption) grew by 17.6% and 13.8% in 2001 and 2002, respectively, while private

consumption increased by lower rates of 2.8% and 4.2% over the same period.


- The threshold for the completion of the statistical forms for each remittance to or receipt of

funds from, nonresidents was raised from amounts exceeding RM 50,000 to RM 100,000 or its

equivalent in foreign currency.

- Controls were imposed on banks to limit outstanding noncommercial-related ringgit offer-side

swap transactions (i.e., forward order/spot purchases of ringgit by foreign customers) to $2

million per foreign customer or its equivalent. Hedging requirements of foreigners for trade-

related and genuine portfolio and foreign direct investment investments were excluded.

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- Residents are allowed to enter into non-commercial-related swap transactions up to a limit (no

limits previously).

- A ban on short-selling of the listed securities on KLSE was introduced to limit speculative

pressures on stock prices and exchange rates.

1998-1999

In this reassessment of capital controls, recent experience in Malaysia—which reimposed

capital controls in September 1998—has been central to the two main views on capital controls.

The more established view emphasizes macroeconomics. If a country faces a severe external

crisis, particularly one caused by pure panic, and if orthodox macroeconomic policies have

failed to restore confidence, Krugman (1998) argues that imposing capital controls may be an

effective way to stabilize the economy.

More generally, Bhagwati (1998a, 1998b) and Rodrik (2000) oppose the conventional wisdom

that free capital flows help countries benefit from trade liberalization and argue instead that

capital market liberalization invites speculative attacks. In this context, Malaysia’s experience

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has been interpreted as demonstrating that capital controls can have positive macroeconomic

effects (Kaplan and Rodrik, 2001), but this claim is controversial and was forcefully opposed by

Dornbusch (2001).

The second view of capital controls puts greater emphasis on institutions (i.e., the rules,

practices, and organizations that govern an economy). Specifically, Rajan and Zingales (1998)

argue that capital controls are an essential part of the package of policies that allows

“relationship-based” capitalism to function. In this system, informal relationships between

politicians and banks channel lending toward approved firms, and this is easier to sustain when

a country is relatively isolated from international capital flows. If capital controls are relaxed, as

in some parts of Asia in the early 1990s, the result may be overborrowing and financial collapse

(Rajan and Zingales, 1998).

Theoretically, relaxing capital controls can lead to financial distress in at least three ways. First,

local financial institutions respond by taking on more risk. Second, local firms borrow directly

from international lenders who are either unable to assess risks appropriately or believe that

there is an implicit sovereign guarantee. Third, after they lose their monopolies, local banks are

less willing to bail out firms that encounter problems, as discussed in Petersen and Rajan

(1995).

In this context, Rajan and Zingales (2003) suggest that reimposing capital controls may be

attractive if it enables politicians to support the financing of particular firms. If this view is correct,

we should expect capital controls to be associated with more resources for favored firms. In the

context of economic crises, there are two testable implications at the firm level. Firms with

stronger political connections should (1) suffer more when a macroeconomic shock reduces the

government’s ability to provide advantages, and (2) benefit more when the imposition of capital

controls allows a higher level of support for particular firms.

For the macroeconomic debate, the Malaysian experience is inconclusive. The capital controls

worked in the sense that they were not circumvented on a large scale. They also never came

under serious pressure, however, controls might have played a preventive role— that is, to

guard against risks to financial stability―but they were never tested in this role. At the same

time, there is no convincing evidence of adverse macroeconomic consequences from the

controls.

At the time of the Asian crisis, portfolio flows were generally free of restrictions. Domestic and

international credit transactions in foreign currency were carefully controlled, but international

trade and financial transactions denominated in ringgit were allowed and perhaps even

promoted. As a result, an active and largely unregulated offshore market in ringgit developed.

After Thailand devalued in July 1997, the Malaysian ringgit came under severe pressure.

Portfolio outflows intensified (Figure 1) and foreign exchange reserves plummeted (Figure 2).

As currency traders took speculative positions against the ringgit in the offshore market,

offshore ringgit interest rates rose markedly relative to onshore rates (Figure 3). This further

intensified the movement of ringgit funds offshore.

The initial response of the authorities was to tighten macroeconomic policies. The Malaysian

authorities intervened heavily in the foreign exchange market and sharply raised interest rates in

July 1997. These measures were abandoned after a few days. In August 1997, the authorities

introduced limits on ringgit swap transactions with nonresidents to stabilize the offshore market.

They also restricted trading in blue chip stocks on the Kuala Lumpur stock exchange. For more

details, see Meesook and others (2001).

Spending cuts were introduced in 1997, and the 1998 budget was drafted to target a surplus of

2½ percent of GDP. Base lending rates were allowed to rise somewhat in response to higher

interbank interest rates (Figure 4), and lending targets were adjusted to reduce growth of credit

for financing purchases of real estate and securities. These measures had little stabilizing

impact on financial markets as crisis continued to spread in the region. When the extent of the

output collapse became clearer, by early 1998, fiscal policy became more expansionary. The

target for the 1998 budget was relaxed to a surplus of ½ percent of GDP in March 1998. A

package of measures to strengthen the financial sector was also introduced at the same time.

In early September 1998, arguing that the measures and reforms that had been put in place by

all countries affected by the Asian crisis did not appear to be returning stability to financial

markets, the Malaysian authorities imposed capital controls and pegged the ringgit to the U.S.

dollar. To close the offshore market in ringgit and ringgit assets, investors were required to

repatriate all ringgit held offshore back to Malaysia, licensed offshore banks were prohibited

from trading in ringgit assets, and residents were prohibited from granting or receiving ringgit

credit vis-à-vis nonresidents. Among supporting measures, the authorities prohibited offshore

trading of ringgit assets and brought to a halt long-standing trading in Malaysian shares in

Singapore. In addition to controls on international transactions in the ringgit, the authorities

imposed controls on portfolio outflows, particularly a one-year holding period on nonresidents’

repatriating proceeds from the sale of Malaysian securities and a prior approval

requirement―above a certain limit―for residents to transfer capital abroad.

The controls were carefully designed to withstand pressure―i.e., to close all known channels

and loopholes for the supply of the ringgit to the offshore market and major portfolio

outflows―while attempting not to affect foreign direct investment and current account

convertibility. The authorities also stressed the temporary nature of controls. Furthermore, a

number of pre-conditions facilitated the implementation of capital controls—a history of using

some controls, effective state capacity, and generally strong bank supervision and regulation

(Meesook and others, 2001; Latifah, 2002).


- A requirement introduced to repatriate all ringgit held offshore (including ringgit deposits in

overseas banks) by October 1, 1998 (BNM approval thereafter).

- Approval requirement was imposed to transfer funds between external accounts (freely allowed

previously) and for the use of funds other than permitted purposes (i.e., purchase of RM

assets).

- Licensed offshore banks were prohibited to trade in ringgit assets (allowed up to permitted limits

previously).

- A limit was introduced on exports and imports of ringgit by residents and nonresident travelers,

effective September 1, 1998 (no limits existed previously).

- Residents were prohibited from granting ringgit credit facilities to nonresident corresponding

banks and stockbroking companies (subject to a limit previously). Residents were prohibited

from obtaining ringgit credit facilities from nonresidents (subject to a limit previously).

- All imports and exports were required to be settled in foreign currency.

- All purchases and sales of ringgit facilities can only be transacted through authorized depository

institutions. A 12-month waiting period for nonresidents to convert RM proceeds from the sale of

Malaysian securities held in external accounts (excluding FDI, repatriation of interest, dividends,

fees, commissions, and rental income from portfolio investment). No such restrictions

previously.

- A prior approval requirement beyond a certain limit for all residents to invest abroad in any form

(previously applied only to corporate residents with domestic borrowing).

- No restriction on conversion of ringgit funds in external accounts of nonresidents with work

permits, embassies, high commissions, central banks, international organizations, and missions

of foreign countries in Malaysia.

- Designated nonresident accounts for futures trading are allowed and exempt from the 12-month

holding period.

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1999-2000


- Funds arising from sale of securities purchased by nonresidents on the CLOB can be

repatriated without payment of exit levy.

- Nonresident controlled companies raising dom credit through private debt securities were

exempted from RM 19 million limit and the 50:50 requirement for issuance of private debt

securities on tender basis through the fully automated system for tendering, to develop domestic

bond market.

- Residents and nonresidents were no longer required to make a declaration in the traveler's

declaration form as long as they carry currency notes and/or travelers' checks within the

permissible limits. For nonresidents, the declaration was incorporated into the embarkation card

issued by the Immigration department.

- Licensed offshore banks in the Labuan international offshore fin center were allowed to invest in

RM assets and instruments in Malaysia for their own accounts only and not on behalf of clients.

The investments could not be financed by ringgit borrowing.

- Foreign-owned banks in Malaysia were allowed to extend up to 50 percent (previously 40

percent) of the total domestic credit facilities to nonresident controlled companies, in case of

credit facilities extended by resident banks. This is to fulfill Malaysia's commitment under the

GATS.

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- Licensed com banks were allowed to extend intraday overdraft facilities not exceeding RM 200

mil in aggregate and overnight facilities not exceeding RM 10 mil (previously 5 mil) to foreign

stockbroking companies and foreign global custodian banks.

- All controls on the trading of futures and options by nonresidents on the MDEX were eliminated.

The Commodity and Monetary Exchange of Malaysia and the KLSE were merged to form the

MDEX.

And from now on…

In addition to Fitch’s base‐case scenario for last year, 2008, of weaker global and Emerging

Asian growth, there are several risks to consider :

A recession in the US – as opposed to a slowdown – could have much more significant

effects on Emerging Asian balance of payments positions.

A pronounced decline of the US dollar – as opposed to more measured, gradual

weakness – could force Asian currencies higher, affecting regional competitiveness. This

would be all the more concerning if a much weaker dollar were accompanied by a much

weaker US economy.

Inflation is rising in several Emerging Asian economies. If inflation continues to

accelerate and balance of payments inflows continue to apply upward pressure on

regional exchange rates, real appreciations could be inevitable. Raising policy interest

rates to curtail inflation may not appeal to regional central banks if economic growth is

slowing and higher rates attract capital inflows, adding to appreciation tendencies.

Figure 6. Role of Fiscal Priming in GDP Growth, Malaysia, 1998-2002.

The effects of a slowdown in US growth on Emerging Asia could be greatly amplified by a US

recession. In a downturn, Asian exporters are likely to have options in terms of seeking

alternative export markets, adjusting prices to retain market share in the US, or temporarily

absorbing losses. These options may disappear in a recession scenario. A US recession,

especially if prolonged, would result in a much weaker export performance, with consequent

effects on Emerging Asian growth. The region could lose its relative attractiveness in terms of

international capital flows, possibly testing the resilience of external balance sheets. Fiscal

pressures would almost certainly be more pronounced.

Leading into 2009, one of the most important macroeconomic questions for Emerging Asia is

how the region might cope with a slowdown in US GDP growth, which is expected to be

accompanied by weaker growth across industrialized economies.

The Malaysian economy has been resilient in the first-half of 2008, but is not going to be

insulated from the global downturn. As the external sector worsened, GDP growth has subsided

to 4.7 per cent in 3Q08 after a strong 7.1 per cent gain in the first-half of '08 (revised upwards

from 6.7%), bringing growth to an average of 6.3 per cent in the first three quarters of '08.

Resilient private consumption, steady public investment and higher fiscal spending supported

the growth in 3Q08. Malaysia has no direct exposure to the US market but is increasingly

feeling the shock from the slowing global economy through trade and investment linkages.

Fearing a dismal global outlook that would hurt the domestic economy, the government

stretched its fiscal deficit to 4.8 per cent in '08, reversing a 7-year progressive deficit reduction.

A RM7 billion stimulus package, to be financed by savings from subsidy reduction, was unveiled

in Nov'08 as a measure to stimulate domestic demand. The deficit fiscal target for 2009 has

also been raised to 4.8 per cent of GDP, from 3.6 per cent previously. This may be justified as

difficult times call for drastic measures. However, there are concerns that government revenue

would be adversely affected by the falling commodity prices, which could subsequently enlarge

the deficit to even exceed 5.0 per cent of GDP, especially now that there is a possibility of an

additional stimulus package being introduced by mid-2009. There is also the longer-term worry

over the high dependency on oil revenue to finance fiscal spending. With most spending going

into construction projects, there are questions over the delivery speed and the potential

leakages from payments to foreign workers and the imports of construction materials, which

would blunt the multiplier effects.

Monthly indicators up to Nov'08 are losing momentum markedly. Industrial output has

contracted in three successive months, as the export-oriented sectors faced diminishing

demand. Total exports have declined for two months in a row, with imports showing steeper

declines, resulting in sustained trade surplus. With prices climbing down, export revenues from

commodities are growing at a slower pace. Thanks to reduction in domestic oil prices, inflation

has eased to 5.7 per cent in Nov'08, down from a peak of 8.5 per cent in Aug'08. Inflation will

likely subside further in tandem with the softening economy.

REFERENCE

Bhagwati, J., 1998a, “The Capital Myth,” Foreign Affairs, May/June, pp. 7–12.

_____, 1998b, “Why Free Capital Mobility May Be Hazardous to Your Health: Lessons from the Latest Financial Crisis?” paper presented at NBER Conference on Capital Controls, November 7.

Dornbusch, R., 2001, “Malaysia: Was It Different?” NBER Working Paper No. 8325 (Cambridge, Massachusetts: National Bureau of Economic Research).

Jomo, K.S., 2001, Malaysian Eclipse: Economic Crisis and Recovery (London and New York: Zed Books).

Kaplan, E., and D. Rodrik, 2001, “Did the Malaysian Capital Controls Work?” NBER Working Paper No. 8142 (Cambridge, Massachusetts: National Bureau of Economic Research).

Krugman, P., 1998, “Saving Asia: It’s Time to Get Radical?” Fortune, September 7.

Latifah, M.C., 2002, “Capital Flows and Capital Controls: The Malaysian Experience,” in Globalization and the Asian Pacific Economy, ed. by Kyung Tae Lee (London and New York: Routledge).

Meesook, K., and others, 2001, Malaysia: From Crisis to Recovery, IMF Occasional Paper No. 207 (Washington: International Monetary Fund).

Petersen, M., and R. Rajan, 1995, “The Effect of Credit Market Competition on Lending Relationships,” Quarterly Journal of Economics, Vol. 110, pp. 407–43.

Rajan, R., L. Zingales, 1998, “Which Capitalism? Lessons from the East Asian Crisis,” Journal of Applied Corporate Finance, Vol. 11, pp. 40–48.

_____, 2003, “The Great Reversals: the Politics of Financial Development in the 20 th Century,” Journal of Financial Economics, Vol. 69, pp. 5–50.

Rodrik, D., 2000, “Exchange Rate Regimes and Institutional Arrangements in the Shadow of Capital Flows” (unpublished; Cambridge, Massachusetts: Harvard University Working Paper).

malaysia is-lm analysis

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